Transcript FIN 365 Business Finance

FIN 614 Financial Management
Topic 19: Capital Structure
Larry Schrenk, Instructor
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Topics
• Leverage
• Miller-Modigliani Propositions
• Financial Distress, etc.
• Bankruptcy
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Capital Structure and the Pie
• The value of a firm is defined to be the sum
of the value of the firm’s debt and the firm’s
equity.
V=B+S
• If the goal of the firm’s
management is to make the firm
as valuable as possible, then the
firm should pick the debt-equity
ratio that makes the pie as big as
possible.
S B
Value of the Firm
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Stockholder Interests
There are two important questions:
1.Why should the stockholders care about
maximizing firm value? Perhaps they should be
interested in strategies that maximize
shareholder value.
2.What is the ratio of debt-to-equity that
maximizes the shareholder’s value?
As it turns out, changes in capital structure
benefit the stockholders if and only if the value
of the firm increases.
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Financial Leverage, EPS, and ROE
Consider an all-equity firm that is considering going into
debt. (Maybe some of the original shareholders want to
cash out.)
Current
Assets
$20,000
Debt
$0
Equity
$20,000
Debt/Equity ratio 0.00
Interest rate
n/a
Shares outstanding 400
Share price
$50
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Proposed
$20,000
$8,000
$12,000
2/3
8%
240
$50
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EPS and ROE Under Current Structure
RecessionExpectedExpansion
EBIT
$1,000 $2,000 $3,000
Interest
0
0
0
Net income$1,000 $2,000 $3,000
EPS
$2.50
$5.00
$7.50
ROA
5%
10%
15%
ROE
5%
10%
15%
Current Shares Outstanding = 400
shares
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EPS and ROE Under Proposed Structure
RecessionExpectedExpansion
EBIT
$1,000 $2,000 $3,000
Interest
640
640
640
Net income $360 $1,360 $2,360
EPS
$1.50
$5.67
$9.83
ROA
1.8%
6.8%
11.8%
ROE
3.0%
11.3%
19.7%
Proposed Shares Outstanding = 240
shares
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Financial Leverage and EPS
12.00
Debt
10.00
EPS
8.00
6.00
4.00
No Debt
Advantage
to debt
Break-even
point
2.00
0.00
1,000
(2.00)
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Disadvantag
e to debt
2,000
3,000
EBIT in dollars, no taxes
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Assumptions of the Miller-Modigliani
(MM) Model
•
•
•
•
Homogeneous Expectations
Homogeneous Business Risk Classes
Perpetual Cash Flows
Perfect Capital Markets:
– Perfect competition
– Firms and investors can borrow/lend at the same
rate
– Equal access to all relevant information
– No transaction costs
– No taxes
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Homemade Leverage: An
Example
Recession Expected Expansion
EPS of Unlevered Firm
$2.50
$5.00
$7.50
Earnings for 40 shares
$100
$200
$300
Less interest on $800 (8%)
$64
$64
$64
Net Profits
$36
$136
$236
ROE (Net Profits / $1,200)
3.0%
11.3%
19.7%
We are buying 40 shares of a $50 stock, using $800 in margin.
We get the same ROE as if we bought into a levered firm.
Our personal debt-equity ratio is:
B $800
S
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
$1,200
2
3
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Homemade (Un)Leverage: An Example
RecessionExpected Expansion
EPS of Levered Firm
$1.50
$5.67
$9.83
Earnings for 24 shares
$36
$136
$236
Plus interest on $800 (8%) $64
$64
$64
Net Profits
$100
$200
$300
ROE (Net Profits / $2,000)
5%
10%
15%
Buying 24 shares of an otherwise identical levered firm
along with some of the firm’s debt gets us to the ROE
of the unlevered firm.
This is the fundamental insight of M&M
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MM Proposition I (No Taxes)
• We can create a levered or
unlevered position by adjusting
the trading in our own account.
• This homemade leverage suggests
that capital structure is irrelevant
in determining the value of the
firm:
VL = VU
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3 MM Proposition II (No Taxes)
• Proposition II
– Leverage increases the risk and return to
stockholders
Rs = R0 + (B / SL) (R0 - RB)
RB is the interest rate (cost of debt)
Rs is the return on (levered) equity (cost of
equity)
R0 is the return on unlevered equity (cost of
capital)
B is the value of debt
SL is the value of levered equity
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MM Proposition II (No Taxes)
The derivation is straightforward:
RW ACC 
B
S
 RB 
 RS
BS
BS
B
S
 RB 
 RS  R0
BS
BS
Then set RWACC  R0
BS
multiply both sides by
S
BS
B
BS
S
BS

 RB 

 RS 
R0
S
BS
S
BS
S
B
BS
 RB  RS 
R0
S
S
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B
B
 RB  RS  R0  R0
S
S
B
RS  R0  ( R0  RB )
S
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Cost of capital: R (%)
MM Proposition II (No Taxes)
R0
RB
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RS  R0 
RW ACC 
B
 ( R0  RB )
SL
B
S
 RB 
 RS
BS
BS
RB
Debt-to-equity Ratio B
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4 MM Propositions I & II (With Taxes)
• Proposition I (with Corporate Taxes)
– Firm value increases with leverage
VL = VU + TC B
• Proposition II (with Corporate Taxes)
– Some of the increase in equity risk and return
is offset by the interest tax shield
RS = R0 + (B/S)×(1-TC)×(R0 - RB)
RB is the interest rate (cost of debt)
RS is the return on equity (cost of equity)
R0 is the return on unlevered equity (cost of capital)
B is the value of debt
S is the value of levered equity
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MM Proposition I (With Taxes)
The total cash flow to all stakeholde rs is
( EBIT  RB B)  (1  TC )  RB B
The present value of this stream of cash flows is VL
Clearly ( EBIT  RB B)  (1  TC )  RB B 
 EBIT  (1  TC )  RB B  (1  TC )  RB B
 EBIT  (1  TC )  RB B  RB BTC  RB B
The present value of the first term is VU
The present value of the second term is TCB
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VL  VU  TC B
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MM Proposition II (With Taxes)
Start with M&M Proposition I with VL  VU  TC B
taxes:
Since VL  S  B  S  B  VU  TC B
VU  S  B(1  TC )
The cash flows from each side of the balance sheet must
equal:
SRS  BRB  VU R0  TC BRB
SRS  BRB  [S  B(1  TC )]R0  TC RB B
Divide both sides by
S
B
B
B
RS  RB  [1  (1  TC )]R0  TC RB
S
S
S
B
Which quickly reduces RS  R0   (1  TC )  ( R0  RB )
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S
to
The Effect of Financial Leverage
Cost of capital: R
(%)
RS  R0 
RS  R0 
B
 ( R0  RB )
SL
B
 (1  TC )  ( R0  RB )
SL
R0
RW ACC 
B
SL
 RB  (1  TC ) 
 RS
BSL
B  SL
RB
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Debt-to-equity
ratio
(B/S)
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All Equity
Total Cash Flow to Investors
EBIT
Interest
EBT
Taxes (Tc = 35%)
Levered
Total Cash Flow to S/H
EBIT
Interest ($800 @ 8% )
EBT
Taxes (Tc = 35%)
Total Cash Flow
(to both S/H & B/H):
EBIT(1-Tc)+TCRBB
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Recession
$1,000
0
$1,000
$350
Expected
$2,000
0
$2,000
$700
Expansion
$3,000
0
$3,000
$1,050
$650
$1,300
$1,950
Recession
$1,000
640
$360
$126
$234+640
$874
$650+$224
$874
Expected
$2,000
640
$1,360
$476
$884+$640
$1,524
$1,300+$224
$1,524
Expansion
$3,000
640
$2,360
$826
$1,534+$640
$2,174
$1,950+$224
$2,174
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Total Cash Flow to Investors
All-equity firm
S
G
Levered firm
S
G
B
The levered firm pays less in taxes than does the all-equity firm.
Thus, the sum of the debt plus the equity of the levered firm is
greater than the equity of the unlevered firm.
This is how cutting the pie differently can make the pie “larger.”–the
government takes a smaller slice of the pie!
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Summary: No Taxes
• In a world of no taxes, the value of the firm is unaffected
by capital structure.
• This is M&M Proposition I:
VL = VU
• Proposition I holds because shareholders can achieve
any pattern of payouts they desire with homemade
leverage.
• In a world of no taxes, M&M Proposition II states that
leverage increases the risk and return to stockholders.
B
RS  R0   ( R0  RB )
SL
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Summary: Taxes
• In a world of taxes, but no bankruptcy costs, the value of
the firm increases with leverage.
• This is M&M Proposition I:
VL = VU + TC B
• Proposition I holds because shareholders can achieve
any pattern of payouts they desire with homemade
leverage.
• In a world of taxes, M&M Proposition II states that
leverage increases the risk and return to stockholders.
B
RS  R0   (1  TC )  ( R0  RB )
SL
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Costs of Financial Distress
• Direct Costs
– Legal and administrative costs
• Indirect Costs
– Impaired ability to conduct business (e.g.,
lost sales)
– Agency Costs
• Selfish Strategy 1: Incentive to take large risks
• Selfish Strategy 2: Incentive toward
underinvestment
• Selfish Strategy 3: Milking the property
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Example: Company in Distress
Assets
BV MV
Cash
$200 $200
Fixed Asset $400
$0
Total
$600 $200
Liabilities
LT bonds
Equity
Total
BV MV
$300
$300 $20
$600 $200
0$0
What happens if the firm is liquidated today?
The bondholders get $200; the shareholders get
nothing.
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Selfish Strategy 1: Take Risks
The Gamble
Win Big
Lose Big
Probability
10%
90%
Payoff
$1,000
$0
Cost of investment is $200 (all the firm’s cash)
Required return is 50%
Expected CF from the Gamble = $1000 × 0.10
+ $0 = $100
NPV = –$200 +
$100
(1.50)
NPV = –$133
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Selfish Strategy 1: Take Risks
• Expected CF from the Gamble
– To Bondholders = $300 × 0.10 + $0 = $30
– To Stockholders = ($1000 – $300) × 0.10 +
$0 = $70
• PV of Bonds Without the Gamble = $200
• PV of Stocks Without the Gamble = $0
• PV of Bonds With the Gamble:
• PV of Stocks With the Gamble:
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$30
$20 =
(1.50)
$47 =
$70
(1.50)
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Selfish Strategy 2:
Underinvestment
• Consider a government-sponsored project that
guarantees $350 in one period.
• Cost of investment is $300 (the firm only has $200
now), so the stockholders will have to supply an
additional $100 to finance the project.
• Required return is 10%.
$350
NPV = –$300 +
(1.10)
NPV = $18.18
Should we accept or reject?
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Selfish Strategy 2:
Underinvestment
Expected CF from the government
sponsored project:
To Bondholder = $300
To Stockholder = ($350 – $300) = $50
PV of Bonds Without the Project = $200
PV of Stocks Without the Project = $0
$300
PV of Bonds With the Project: $272.73 =
(1.10)
$50
– $100
PV of Stocks With the Project: – $54.55 =
(1.10)
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Selfish Strategy 3: Milking the Property
• Liquidating dividends
– Suppose our firm paid out a $200 dividend
to the shareholders. This leaves the firm
insolvent, with nothing for the
bondholders, but plenty for the former
shareholders.
– Such tactics often violate bond
indentures.
• Increase perquisites to
shareholders and/or management
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Can Costs of Debt Be Reduced?
• Protective Covenants
• Debt Consolidation:
– If we minimize the number of parties,
contracting costs fall.
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Tax Effects and Financial Distress
• There is a trade-off between the
tax advantage of debt and the
costs of financial distress.
• It is difficult to express this with a
precise and rigorous formula.
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Tax Effects and Financial Distress
Value of firm under
MM with corporate
taxes and debt
Value of firm (V)
Present value of tax
shield on debt
VL = VU + TCB
Maximum
firm value
Present value of
financial distress costs
V = Actual value of firm
VU = Value of firm with no debt
0
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Debt (B)
B*
Optimal amount of debt
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The Pie Model Revisited
• Taxes and bankruptcy costs can be viewed as just
another claim on the cash flows of the firm.
• Let G and L stand for payments to the government and
bankruptcy lawyers, respectively.
• VT = S + B + G + L
S
B
G
L
• The essence of the M&M intuition is that VT depends on
the cash flow of the firm; capital structure just slices the
pie.
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Signaling
• The firm’s capital structure is optimized where the
marginal subsidy to debt equals the marginal cost.
• Investors view debt as a signal of firm value.
– Firms with low anticipated profits will take on a low level of
debt.
– Firms with high anticipated profits will take on a high level
of debt.
• A manager that takes on more debt than is optimal
in order to fool investors will pay the cost in the long
run.
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The Agency Cost of Equity
• An individual will work harder for a firm if he is one of the
owners than if he is one of the “hired help.”
• While managers may have motive to partake in perquisites,
they also need opportunity. Free cash flow provides this
opportunity.
• The free cash flow hypothesis says that an increase in
dividends should benefit the stockholders by reducing the
ability of managers to pursue wasteful activities.
• The free cash flow hypothesis also argues that an increase in
debt will reduce the ability of managers to pursue wasteful
activities more effectively than dividend increases.
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The Pecking-Order Theory
• Theory stating that firms prefer to issue debt rather
than equity if internal financing is insufficient.
– Rule 1
• Use internal financing first.
– Rule 2
• Issue debt next, new equity last.
• The pecking-order theory is at odds with the
tradeoff theory:
– There is no target D/E ratio.
– Profitable firms use less debt.
– Companies like financial slack.
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The Debt-Equity Ratio
• Growth implies significant equity
financing, even in a world with low
bankruptcy costs.
• Thus, high-growth firms will have
lower debt ratios than low-growth
firms.
• Growth is an essential feature of the
real world. As a result, 100% debt
financing is sub-optimal.
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How Firms Establish Capital Structure
• Most corporations have low Debt-Asset ratios.
• Changes in financial leverage affect firm value.
– Stock price increases with increases in leverage and
vice-versa; this is consistent with M&M with taxes.
– Another interpretation is that firms signal good news
when they lever up.
• There are differences in capital structure across
industries.
• There is evidence that firms behave as if they had
a target Debt-Equity ratio.
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Factors in Target D/E Ratio
• Taxes
– Since interest is tax deductible, highly profitable firms
should use more debt (i.e., greater tax benefit).
• Types of Assets
– The costs of financial distress depend on the types of assets
the firm has.
• Uncertainty of Operating Income
– Even without debt, firms with uncertain operating income
have a high probability of experiencing financial distress.
• Pecking Order and Financial Slack
– Theory stating that firms prefer to issue debt rather than
equity if internal financing is insufficient.
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The Bankruptcy Process
• Business failure – business has
terminated with a loss to creditors
• Legal bankruptcy – petition
federal court for bankruptcy
• Technical insolvency – firm is
unable to meet debt obligations
• Accounting insolvency – book
value of equity is negative
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The Bankruptcy Process
• Liquidation
– Chapter 7 of the Federal Bankruptcy Reform
Act of 1978
– Trustee takes over assets, sells them, and
distributes the proceeds (Absolute Priority
Rule)
• Reorganization
– Chapter 11 of the Federal Bankruptcy
Reform Act of 1978
– Restructure the corporation with a provision
to repay creditors
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